Sunday, January 1, 2012

Keynes’s Marginal Efficiency of Capital: A Mistake?

It is very interesting to note what Joan Robinson thought of Keynes’s notion of the marginal efficiency of capital:

“[sc. Keynes] made a fatal mistake in offering a quasi-long-period definition of the inducement to invest as the ‘marginal efficiency of capital’, that is, the profit that will be realised on the increment to the stock of capital that results from current investment and, still worse, identified the profitability of capital with its social utility. This was an element in the old doctrine from which he failed to escape. He had an alternative concept of the inducement to invest as the expected future return on sums of finance to be devoted to investment. Minsky (1976) points out that he did not seem to recognise the difference between the two formulations. If he had stuck to his short-period brief, he would have used only the second.” (Robinson 1979: 179–180).

I have seen other criticisms of the marginal efficiency of capital idea, on the grounds that Keynes, in developing it, failed to free himself from the neoclassical marginal productivity of capital (King 2002: 209). Keynes was also influenced by Sraffa’s own rates of interest concept (Barens and Caspari 1997: 294). In fact, Knut Wicksell’s natural interest rate concept, by one of his definitions, appears rather similar to the marginal efficiency of capital:

“The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yields on the newly created real capital, will then be the normal or natural rate. It is essentially variable. If the prospects of employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. At the same time equilibrium must ipso facto obtain—broadly speaking, and if it is not disturbed by other causes—in the market for goods and services, so that wages and prices remain unchanged” (Wicksell 1934: 193).

The natural rate or “the expected yields on the newly created real capital” is the analogue of the marginal efficiency of capital (Uhr 1994: 94). But Keynes’s marginal efficiency of capital is arguably not a “real” concept: the marginal efficiency of capital is a rate expressed in terms of money.

BIBLIOGRAPHY

Barens, I. and V. Caspari, 1997. “Own-Rates of Interest and Their Relevance for the Existence of Underemployment Equilibrium Positions,” in G. C. Harcourt and P. A. Riach (eds.), A “Second Edition” of The General Theory (Vol. 1), Routledge, London. 283–303.

Lawlow, M. S. 1994. “The Own-Rates Framework as an Interpretation of the General Theory: A Suggestion for Complication the Keynesian Theory of Money,” in J. B. Davis (ed.). The State of Interpretation of Keynes, Kluwer Academic, Boston and London. 39–90.

5 comments:

"But Keynes’s marginal efficiency of capital is arguably not a “real” concept: the marginal efficiency of capital is a rate expressed in terms of money."

Keynes expressed it in terms of money yes, but the reasons he gave for why it will rise or fall is due to "real" factors.

Keynes advanced three reasons why the "marginal efficiency of capital" would fall.

1. As more net investment took place to offset the additional saving accompanying the additional employment, the prices of capital assets would rise, in response to the increase in demand for capital assets allegedly constituted by the additional net investment. Criticism: In the context of FALLING wage rates and prices, the prices of capital assets would fall, not rise. The additional net investment presupposes and is in response to lower prices of capital assets, and can endure only so long as the prices of the capital assets are lower. Keynes conflated the increase in the quantity of a good demanded that takes place in response to a lower price of the good, with an increase in the demand for the good.

2. More net investment means more capacity in place, which means lower selling prices of products, which, other things being equal, means a fall in profitability. Criticism: Other things are NOT equal. The fall in wage rates and prices is what brings about the additional production and the decline in prices. Lower prices founded on lower costs of production do not reduce profitability or the marginal efficiency of capital.

3. Diminishing returns would accompany the additional net investment that was required to offset the additional saving taking place as employment, output, and real income expanded. Criticism: In the context of a depression, falling wage rates and prices would see an increase in the ratio of labor to capital goods. In a recovery out of depression, the supply of employed labor increases at a more rapid pace than the supply of capital goods, since substantial quantities of machines and factories previously used in production are idle. As workers come back into the factories and once again take up the use of capital goods, the ratio of capital to labor drastically falls, and physical returns to capital drastically rises. The secondary increase in capital goods that accompanies more employment is purely a derivative phenomenon, that is dominated by the primary phenomenon of increasing returns to capital as a result of idle resources again being utilized.

All three of these reasons for declining marginal efficiency of capital have "real" origins, which as shown are all false, but they have results in terms of money, which is a secondary, not a primary, phenomenon.

Notice how Wicksell explains the "natural rate" as being constituted in the market by multiple rates with an "s":

"The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yields on the newly created real capital, will then be the normal or natural rate. It is essentially variable. If the prospects of employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. At the same time equilibrium must ipso facto obtain—broadly speaking, and if it is not disturbed by other causes—in the market for goods and services, so that wages and prices remain unchanged"

I am sure that Wicksell, like all Austrians, know that in the market, multiple rates exist. The "natural rate" can be argued to be an abstract reference to the rates that would have otherwise existed in the absence of Fed/FR manipulation.

Sraffians do not like chapter 17 of the General Theory, and they certainly don't like the Marginal Efficiency of Capital (which appears in other chapter, I know). You should look for a discussion between Paul Davidson and Gary Mongiovi on the subject. It's in a book called "Interactions in Political Economy, Malvern after 10 years", edited by Steven Pressman (by the way, he wrote a great critique of Public Choice Theory, a subject you may want to talk about as it is, I believe, a cornerstone of Neoclassical and even Austrian attitudes towards public policy).Pablo.

Jan said:Lord Keynes!Ha ha!Yes that Christof most be joking!So now the founder of "Stockholm schoool of economics",old Swede Knut Wicksell are an "Austrian"?He was mentor to several justifiably famous Swedish economists who followed him, and one of the most influential economists of his time!Now are ,old radical,Swedish economist Knut Wicksell, suddenly reduced to be some "Austrian schoolar"??A footnote in Hayek´s work maybee??Do they know old Wicksell questioned the institutions of rank, marriage, the church and monarchy, and the military,fought for a more equal distribution of wealth and income?Advocated Progressive taxation,counter-cyclical budgets,low interest rates during recessions etc?Half of his work is in Swedish,so i guess they got him backwards!